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**INTEREST RATE DERIVATIVE PRICING
**

Multi-Curve Extension of the Stochastic-Volatility Forward LIBOR Market Model

大学院商学研究科 修士課程 金融専攻 Petar Svilenov Sabtchevsky

Contents

1 Introduction 1.1 Contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 Organization of the Thesis . . . . . . . . . . . . . . . . . . . . 2 A Literature Review on Interest Rate Modeling 2.1 Notation . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Short Rate Models . . . . . . . . . . . . . . . . . . . 2.3 Heath-Jarrow-Morton (HJM) Framework . . . . . . . 2.4 Market Models . . . . . . . . . . . . . . . . . . . . . 2.5 Stochastic Volatility Market Models . . . . . . . . . . 2.5.1 The Joshi and Rebonato (2003) Model . . . . 2.5.2 The Andersen and Brotherton-Ratcliﬀe (2005) Model . . . . . . . . . . . . . . . . . . . . . . 2.6 The SABR Model . . . . . . . . . . . . . . . . . . . . 2.7 Pricing in a Distressed Market Environment . . . . . . . . . . . . . . . . . . . . . . . 3 Equilibrium Instantaneous 3.1 Notation . . . . . . . . . 3.2 Preliminaries . . . . . . 3.3 The Financial Market . . 3.4 The Economy . . . . . . Interest Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Derivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 5 5 7 7 8 9 11 13 14

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4 Multi-curve Extension of the SV Forward-LIBOR Model 4.1 Preliminaries . . . . . . . . . . . . . . . . . . . . . 4.2 Model Deﬁnition . . . . . . . . . . . . . . . . . . . 4.3 Solution of the Multi-curve Stochastic Volatility LIBOR Market Model . . . . . . . . . . . 1

Market 33 . . . . . . 33 . . . . . . 36 . . . . . . 39

2 4.4 Caplet Pricing in the Multi-curve Stochastic Volatility Forward-LIBOR Market Model . . . . . . . . . . . . . . . 4.5 Multi-curve Stochastic Volatility LIBOR Dynamics under Diﬀerent Measures . . . 4.6 Interest Rate Derivative Pricing in the Extended Model . . . . . . . . . . 4.7 Multi-curve Extension of the Stochastic Volatility Forward-Swap Market Model . 5 Conclusion

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Chapter 1 Introduction

Financial markets for interest rate contingent claims are at the forefront of global ﬁnancial activity. In addition to being colossal in notional terms, they are also characterized by a higher order of complexity than are markets in other ﬁnancial instruments, such as equity derivatives. Consequently, interest rate modeling and the pricing of interest rate contingent claims have been two major topics of research in the ﬁeld of mathematical ﬁnance. Although signiﬁcant progress has been made over the past decades, a universal model, capable of pricing a wide range of exotic interest rate instruments in a consistent fashion, is yet to be proposed. The conventional approach to building interest rate derivative pricing models, prior to the global ﬁnancial crisis of 2007-2009, was to bootstrap the spot curve by extrapolation and interpolation of the spot rates of liquid instruments, observed in the market. Then, discounting and forwarding curves were derived from the bootstrapped spot curve. Using these curves and relevant market data, one could calibrate a model of choice and price an arbitrary interest rate contingent claim. As we discuss in the following chapters, the state-of-the-art pricing model, in the pre-crisis environment, was the Forward-LIBOR market model. This model was capable of pricing multiple exotic and plain-vanilla instruments in a consistent fashion. When confronted with the problem of pricing interest rate contingent claims in a distressed market environment, e.g., in the aftermath of the global ﬁnancial crisis of 2007-2009, it is advisable to avoid the pre-crisis pricing approach. This is because considerable basis spreads, such as 3M 3

4 LIBOR-OIS∗ (EONIA) spreads, tenor† basis spreads, and cross-currency basis spreads, induced by liquidity and credit risk, are observed even between similar‡ instruments in a distressed market environment. Each set of instruments, grouped by tenor, inhabits its own universe and carries its own speciﬁc liquidity and credit risk premia. If liquidity decreases as tenor length increases, longer tenors would lead to increases in both liquidity and credit risk premia. Surely, a robust post-crisis pricing model should be capable of adequately incorporating liquidity and credit risk premia into the price of the instrument. If the LIBOR-OIS (EONIA) spread is close to zero, LIBOR rates can be perceived as risk-free and used for discounting. During the global ﬁnancial crisis, however, when the LIBOR-OIS (EONIA) spread was of the order of several hundred basis points, this situation was not the case. In the aftermath of the crisis, the LIBOR-OIS (EONIA) spread has shrunk considerably, but it is still far from zero, owing to the fact that the LIBOR rates incorporate credit risk (generic counterparty risk). Clearly, the LIBOR rate is not riskfree and is not to be used for discounting in interest rate derivative pricing models. In this thesis, we develop a theoretical pricing framework within which interest rate instruments of diﬀerent tenors can be valued in a distressed market environment, without inconsistencies and allowing for no arbitrage opportunities. The pricing framework we propose consists of multiple forwarding curves (one forwarding curve for each tenor, deﬁned on a submarket) and a single discounting curve. We neither specify the discounting curve in an ad-hoc fashion, nor advocate for it to be estimated from market data. On the contrary, we take a general equilibrium perspective and derive the (equilibrium) discounting curve endogenously. Finally, we propose a multi-curve extension of Piterbarg’s (2010) stochastic volatility Forward-LIBOR market model.

Overnight Index Swap (OIS). Let Tα and Tβ , 0 ≤ Tα < Tβ ≤ T , be two consequential payment dates speciﬁed in the indenture of an arbitrary instrument. Then, we call Tβ − Tα the tenor of that instrument. ‡ Instruments with similar indentures, diﬀering only in their tenors.

†

∗

we augment the multi-curve extension of the stochastic volatility ForwardLIBOR market model with an endogenously derived discounting curve. we propose augmenting the multi-curve extension of the stochastic volatility forward-LIBOR market model with the discounting curve derived in Chapter 3. 1. Second. In the concluding part of the survey. First. they are unheard of when it comes to utilizing market models and their extensions. We start Chapter 3 with a description of the basic notation used throughout Chapters 3 and Chapter 4. Although equilibrium approaches in the ﬁeld of interest rate modeling can be traced back to the seminal work of Cox. investigate the problem of interest rate derivative pricing in a distressed market environment. we conduct a survey on interest rate modeling and brieﬂy review some popular interest rate models. we are the ﬁrst to postulate the multi-curve extension of the stochastic volatility ForwardLIBOR market model§ in a rigorous fashion. We pay particular attention to the family of market models and their extensions.5 1. In Chapter 4. . Then. which is used for swaption pricing. Third. We conclude this thesis by showing that our insights can also be applied to the SWAP market model. we present several models developed in the aftermath of the 2007-2009 global ﬁnancial crisis that are suitable for interest rate derivative pricing in a distressed market environment. and Ross (1985). we also solve the model.2 Organization of the Thesis In Chapter 2. and derive the probability process of forwarding rates under diﬀerent probability measures. § We extend the stochastic volatility Forward-LIBOR market model of Piterbarg (2003). we explain why OIS rates and collateralized rates should not be used for discounting and advocate for the usage of a discounting curve that is derived endogenously. Ingersoll.1 Contributions The main contribution of this thesis is threefold. we employ a general equilibrium approach and endogenously derive the equilibrium discounting curve. In Chapter 4.

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Standard terminology and notation are employed without further explanation.1 Notation The notation described below is valid throughout this chapter. For exhaustive exposition on interest rate modeling and interest rate derivative pricing.T ] . 2010c). 7 . P). F . Readers are kindly invited to consult references on stochastic analysis and its application to ﬁnance. with respect to {F (t)}. In addition to presenting a myriad of prominent models. Jeanblanc et al.Chapter 2 A Literature Review on Interest Rate Modeling In this chapter. we brieﬂy review relevant literature on interest rate modeling. We deﬁne a standard Brownian motion W on the ﬁltered probability space (Ω. A process in this chapter is by deﬁnition a stochastic process. generated by the Brownian motion and assume that F = F (T ). we also discuss their limitations. W is assumed to be R-valued. (2009). that is progressively measurable. 2010b. We denote by F the augmented ﬁltration. 2. F. Unless otherwise stated. see Mercurio (2006) and Andersen and Piterbarg (2010a. {F (t)}t∈[0. We devote special attention to the family of market models and to interest-rate modeling in a distressed market environment characterized by wide basis spreads. such as Karatzas and Shreve (1991).

8 2. Q − a.3) are extensions of the Vasiˇ cek model. Q − a. 0 ≤ t ≤ T. √ dr(t) = k [θ − r(t)]dt + σ r(t)dW (t).. dr(t) = k [θ − r(t)]dt + σdW (t). dr(t) = [θ(t) − αr(t)]dt + σdW (t).5) is a common parameterized of the Hull and White (1990) model.. it is possible to calibrate these models to observed market data and to recover the initial term structure of interest rates at inception..s. By using deterministic time-dependent parameters.. The Black and Karasinski (1991) model. The reduced form (2. (2. Additionally. (2. Q − a.s. According to Mercurio (2006). because it mitigates the risk of overﬁtting. whereas θ(·) and α(·) are ﬁtted to market data. The CIR model can be extended in the same way as the Vasiˇ cek model. both the Vasiˇ cek and the CIR models are incapable of modeling the volatility smile. Q − a.2) of Cox. dr(t) = [θ(t) − α(t)r(t)]dt + σ (t)dW (t).s. The most serious deﬁciency of the Vasiˇ cek model is that the short rate can become negative with positive probability.s. d ln(r(t)) = [θ(t) − α(t) ln(r(t))]dt + σ (t)dW (t). (2. Both models are mean reverting with mean reversion speed k ∈ R and mean reversion level θ ∈ R++ . (2. σ (·).s. Ingersoll. and Ross (1985).2 Short Rate Models Short rate models were the ﬁrst models developed for interest rate modeling and pricing of interest rate derivatives. Two of the most widely known short rate models are the Vasiˇ cek (1977) model.4) 0 ≤ t ≤ T. and the Cox-Ingersoll-Ross (CIR) model. where the short rate is nonnegative. α(·). (2. Assuming constant volatility. 0 ≤ t ≤ T. and the Hull and White (1990) model. these models are incapable of ﬁtting to the observed initial term structure of interest rates. The parameter σ is usually estimated from historical data. . θ(·).1) 0 ≤ t ≤ T. 0 ≤ t ≤ T. Q − a. This issue is ameliorated in the CIR model.5) is enticing. The short rate in the Vasiˇ cek model can be computed analytically and has Gaussian distribution.

σd (ω. ρ = 1.. The deterministically-shifted two-factor CIR model. and Piterbarg (2010b). For any initial forward curve T → f (0. Jarrow. 0 ≤ t ≤ T. we summarize the essence of the HJM framework.g. G2++. T ) follows the Itˆ o process ∫ t ∫ t f (t. T )ds + σ (s. T ) ∈ R and σ : Ω × R+ × R+ ∋ (w. Mercurio (2006). 0 0 Lemma 2. 2. but is also at odds with empirical observations. t. T ). In the sequel. CIR2++. the deterministically-shifted two-factor Vasiˇ cek model. between rates of diﬀerent maturities. ∫T ∫T • 0 0 |α(s. (2. t. • sups. T ) → α(ω. T ) + P (s..9 A common shortcoming of all one-factor short rate models and their extensions is that they assume by construction a perfect correlation. P − a. t.7) ∗ 0 We write B for the Borel σ -algebra. t. T )) ∈ Rd are such that • α and σ are Prog ⊗ B ∗ measurable. T ) + α(s. T )]ds (2. t. the forward rate process f (·. Two-factor and multi-factor short rate models were primarily developed to allow for richer correlation structure between rates of diﬀerent maturities. T ). ∀T ..s. e. T ) = P (0.t≤T ||σ (s. and Morton (1992) was a major development in the ﬁeld of interest rate modeling. We assume that α : Ω × R+ × R+ ∋ (ω.6) 0 ∫ t + P (s.1. T )v (s.3. T ) → (σ1 (ω. They modeled the entire forward curve and gave a no-arbitrage drift condition.3 Heath-Jarrow-Morton (HJM) Framework The celebrated work of Heath. . . T )dW (s). For extensive exposition on the subject of short rate models and their extensions see. ∀T . t)|| < ∞. the zero-coupon bond price follows an Itˆ o process of the form ∫ t P (t. This assumption is not only unsound from a theoretical viewpoint. t)|dsdt < ∞. and the HullWhite (1994) two-factor model are some of the most widely used two-factor short rate models.. T )dW (s). T ) = f (0. T )[r(s) + b(s. For every maturity T.

T )γ (t)⊤ .14) . e. ∀T. (2. u)du (2.3.10) In this case.s. u) du ds 0 s ∫ t + σ (s. 0 (2. Now we are ready to state the HJM drift condition as a theorem.g.13) dW Q = dW P − γ ⊤ dt. where v (s. Filipovi´ c (2009).12) (2. Filipovi´ c (2009). ∫ T σ (s.11) (2.. dP F (t) Proof. See.T) are of the form ) ∫ t( ∫ T ⊤ f (t. dP ⊗ dt − a.1. T )||2 .10 for 0 ≤ t ≤ T . T ) = −v (t..8) is the T-bond volatility and b(s. T ) = − s def . def . where W Q is a Q-Brownian motion and (∫ ) dQ P =E γdW (t). See. the Q-dynamics of the forward rates f(t.g. u)du + ||v (s. T ) σ (s. Theorem 2. T ) = f (0. T ) + σ (s. 2 (2. T )dW Q (s). ∫ T 1 α(s. The measure Q is an equivalent martingale measure if and only if b(t. (2. T ) = − s def .9) Proof. e.

QTj − a. we refer to the Lognormal forward-LIBOR market model as the LIBOR market model.s. 0. ) ∫ T ∫ t ∫ t( ⊤ σ (s. T ) (2. Brace (2008) or Bj¨ ork (2008). every arbitrage-free short rate model is also a HJM model. d⟨W Tj (·). Gatarek. Tj −1 . Signiﬁcant contributions to the model were made by Miltersen. Sandmann. T )ds = σ (s.. e. Consequently. σ j (t) = [0.g.11 Every arbitrage-free interest rate model is to meet the HJM drift condition.17) In (2. 0. was introduced by Brace. α(s. (Tj − Tj −1 )P (t. Tj ). We deﬁne the forward rate of maturity Tj by Fj (t) ≡ F (t. QTj )martingale. P (t... (2.. W Tj (·)⊤ ⟩(t) = ρdt..16) From the deﬁnition of Fj (·). 0]..18) W Tj (·) is a d-dimensional column-vector Brownian motion under measure QTj with instantaneous covariance.m . the Lognormal forwardLIBOR market model. The LIBOR market model models the instantaneous forward rate.17). .a2 )a1 . swap rates. σj (t). ρ = (ρa1 . corresponding to the num´ eraire P (t. e.4 Market Models Market models model quantities directly observable in the market.15) 0 0 s Consequently. we adopted Mercurio’s (2006) notation.. (2. it is obvious that Fj (·) follows a (F (·). (2. Tj ) 0 ≤ t ≤ Tj −1 . Tj −1 ) − P (t. is assumed to follow dFj (t) = σ j (t)Fj (t)dW Tj (t)....a2 =1. Tj ) = def . For elementary treatment on the subject see. One major advantage of market models is that they are consistent with Black’s (1976) formula for either caps (LIBOR models) or swaptions (swap rate models). . forward rates. The ﬁrst market model. u) du ds. and Sondermann (1997) and Jamshidian (1997).. In the following subsection. its driftless process under the Tj -forward measure QTj . (2. and Musiela (1997). 0 ≤ t ≤ Tj −1 ..19) . we present the family of market models refereed to as the Modern pricing approach by Rebonato (2002). def . Tj ) . In the sequel. 2.g.

In order to calibrate the LIBOR market model to the caplet market. Obviously. particular functional forms of the volatility vector σ (t).j (t) = † dFi (t)dFj (t) . e. and of the correlation matrix ρ have to be speciﬁed. ∫t σi (τ )σj (τ )dτ √∫ Corr(Fi (t). diﬀerent from 1.3 √∫ 0 (2. t 2 T1 2 σ ( τ ) dτ σ ( τ ) dτ j 0 i 0 between forward rates can be achieved not only by low instantaneous correlation. the following caplet pricing condition should me met† : ∫ Tj−1 1 def . ρij . Std(dFi (t))Std(dFi (t)) (2. we can achieve decorrelation‡ between forward rates. Fj (t)) ≈ ρ2. 0 ≤ t ≤ T .20) Tj −1 0 vTj−1 −caplet stands for the volatility that is to be inserted into Black’s (1976) formula to recover the market price of a caplet with maturity Tj −1 . If the model is not calibrated to the plain-vanilla market. (2. The LIBOR market model is compelling because it also allows us to specify the correlation matrix. We refer the reader to Rebonato (2004) and Mercurio(2006) for further reference on the topic of parameterization. By specifying instantaneous correlations. terminal decorrelation (which is the correlation that matters when we are pricing interest rate derivatives).g.. ‡ |ρ| < 1 .22) A suitable model for pricing exotic interest rate contingent claims should be capable of recovering the market prices of plain-vanilla instruments at inception because plain-vanilla instruments. ρ. such as. Market models in general and the LIBOR market model in particular are superior to short rate models because they can produce more realistic volatility term structures. 2 vTj−1 −caplet = σi (t)2 dt. caps and swaptions.12 In order for the LIBOR market model to be fully speciﬁed. when we are specifying the functional form of the instantaneous volatility σi (·). we are restricted by the caplet pricing condition. As it is explained at length in Mercurio (2006).21) . the hedging cost for an exotic derivative predicted by the model will not match the actual hedging cost incurred in the market. are used as hedging instruments for exotic derivatives. ρi. The functional form of the volatility vector σi (·) should allow for volatility smiles that are consistent with those observed in markets for interest rate derivatives.

we obtain that the dynamics of Fk (·) under the forward-adjusted measure QTi in the three cases i < k. t ≤ Ti : dFk (t) = σk (t)Fk (t) dt 1 + τj Fj (t) j =i+1 Ti +σk (t)Fk (t)dWk (t). i = k. .g. the drifted process of the forward rate in the forward-LIBOR market model is devoid of analytical solution.1).1.. and i > k are respectively. 2.j τk σj (t)Fj (t) : dFk (t) = −σk (t)Fk (t) dt 1 + τ j Fj (t) j =k+1 Ti +σk (t)Fk (t)dWk (t). there is an abundance of empirical evidence showing that volatility is not deterministic but stochastic.j τk σj (t)Fj (t) i < k. consequently we have to resort to Monte Carlo simulations.5 Stochastic Volatility Market Models The LIBOR market model accommodates multiple deterministic volatility speciﬁcations.4. i = k . (2. From Proposition (2. these deterministic speciﬁcations are incapable of realistically predicting the future evolution of the implied volatility. forward rates decorrelation in the LIBOR market model can be achieved in two ways.. t ≤ Tk−1 i > k. k ∑ ρk. An¨ dersen and Andreasen (1999). e. See. σ . (2.25) Proof. Unfortunately.13 but also by appropriate speciﬁcation of the instantaneous volatility. and Eberlein and Ozkan (2005). ρ. Thus. the drift-term of the forward rates obviously depends on the instantaneous correlation.g. and on the state variable. Fj (·).4.24) i ∑ ρk. In general. on the instantaneous volatility. e. Filipovi´ c (2009). Under the lognormal assumption. For some extensions of the Forward-LIBOR market model see. t ≤ Tk−1 (2. In addition to that.23) Ti : dFk (t) = σk (t)Fk (t)dWk (t). Proposition 2.

We next give several examples of stochastic volatility LIBOR market models.27) 0 where fj (y ) is the probability density function of the root-mean-square volatility. dx(t) = λx (rx − x(t))dt + σx dWx (t). dFj (t) = σj (t)[Fj (t) + αj ]dWj j (t).14 The stochastic volatility extensions of the LIBOR market model were primarily developed to ameliorate the these issues. y Tj −1 )fj (y )dy. the process of the volatility σj (·) is measure-invariant. Moreover. QTj − a. 0 ≤ t ≤ Tj −1 . Due to this assumption. K ) (2. τj . This new class of models not only accommodates volatility smiles. Tj . (2. Tj ) Bl(K + αj . Fj (0) + αj . persistent in interest rate derivative markets since the late 1990s. skews.26) ∫ ∞ √ = τj P (0. x ∈ {a. √ ∫ Tj−1 1 2 σj (t)dt.28) Tj −1 0 which is to be simulated by Monte Carlo. 2. ln(d)}. (2.1 The Joshi and Rebonato (2003) Model Joshi and Rebonato (2003) proposed the following stochastic volatility model. ln(c). Tj −1 . 2. caplet prices can be written as integrals of adjusted Black’s prices: Cpl(0.s.s. T 0 ≤ t ≤ Tj −1 . b.2 The Andersen and Brotherton-Ratcliﬀe (2005) Model Under the LIBOR spot measure Q the forward rate Fj (t) follows . Joshi and Rebonato (2003) assume that the Brownian motion driving the process of the forward rate is independent from the Brownian motion driving the process of x. but also predicts the future evolution of the volatility surface.5. σj (t) = [a(t) + b(t)(Tj −1 − t)]e−c(t)(Tj−1 −t) + d(t). and smirks. QTj − a.5.

d⟨Zj . the SABR model is not a term-structure model. T 0 ≤ t ≤ Tj −1 . (2002). proposed by Hagan et al. because it cannot model the joint dynamics of multiple forward rates. 2.29) (2. η .6 The SABR Model The SABR model.32) (2. Resorting to foreign-currency analogy. M. j. W ⟩t = 0.k k k dFj (t) = σj (t) V (t)φ(Fj (t)) V (t) dt + dZj (t) . and ρ. and ρj are the j -th component of respectively ν. . ρj dt = d⟨Z Tj (·).s..33) dσj (t) = σj (t)νj dZ Tj (t).. j = 1. k = 1. βj . 1 + τk Fk (t) k=β (t) 0 ≤ t ≤ Tj −1 ..30) 2. dFj (t) = (Fj (t))βj σj (t)dWj j (t). The process of the forward rate of maturity Tj and its volatility are martingales under the forward measure QTj .15 j ∑ √ √ τ ρ σ ( t ) φ ( F ( t )) k j.. . QTj − a. Zk ⟩t = ρj.M. (2. is also a stochastic volatility model. (2. dV (t) = k (θ − V (t))dt + ϵψ (V (t))dW (t).31) (2. However.s..k dt. Binachetti (2008) derived generalized no-arbitrage double-curve market-like . Q − a. In general.7 Pricing in a Distressed Market Environment A couple of models capable of modeling interest rates in a distressed marked environment were developed in the aftermath of the global ﬁnancial crisis of 2007-2009. νj . QTj − a. d⟨Zj . 0 ≤ t ≤ Tj −1 .. these parameters are diﬀerent for diﬀerent maturities.. Binachetti (2008) was the ﬁrst to address the problem of pricing and hedging of plain-vanilla single-currency interest rate contingent claims in the presence of wide basis spreads.. W Tj (·)⟩(t).s.

s. σ . follow a (F f . Tj −1 . Xf d (t. Tj ) follows dFjf (t) Fjf (t) µf (t) = def . swaps. Clearly. deﬁned on (Ω.42) f ×QAf d (t. Qd j − a.Brownian motion.40) T = Using these results. Tj ) T T 0 ≤ t ≤ Tj −1 . WXj (·)⟩(t) = ρf X (t)dt. F f . Fjf (·) ≡ F f (·. σX ..” where Pf (·.34) as a forward “foreign exchange rate. caps. where Fjf (t) ≡ F f (t. dFjf (t) = σ f (t)Fjf (t)dWf j (t). Binachetti (2008) assumes that the dynamics T T of the “foreign” forward rates.36) (2. Tj ) T = σX (t)dWXj (t). We interpret Xf d (t.s.. Pd (t. Tj )|F (t)] = Ff (t. Tj −1 . Tj ) (2. T ) 0≤t≤T (2. Xf d (t. (2. T ) stand for “foreign” and “domestic” risk-free discount bond prices. Qf j )martingale. Qf j ). we obtain EQd [F f (Tj −1 . T T T (2. µf (t)dt + σ f (t)dWf j (t). T 0 ≤ t ≤ Tj −1 .43) T2 . (2. QTj − a.38) Under the “domestic” Tj -forward measure Qd j . QTj − a. and swaptions. if ζ (Tj ) = F f (Tj −1 . Qf j )-martingale and its process is given by dXf d (t. Tj −1 . T ) .41) where ζ (Tj ) is an arbitrary (F . Tj −1 . T ) = Pf (t. Qf j )-martingale and 0 ≤ t < Tj . (2. Tj −1 . For example. such as FRAs.e. (2..16 formulas for basic plain-vanilla interest rate contingent claims. ρf X ). i. Tj ).37) where WXj (·) is a Qd j .39) (2. T ) T follows a (F f . Bianchetti (2008) assumes that d⟨Wf j (·). T Tj (2.35) T 0 ≤ t ≤ Tj −1 . T ) and Pd (·.. Tj ). −σ f (t)σX (t)ρf X (t)dt.s. we can compute an expectation of the form EQd [ζ (Tj )|F (t)]. Tj −1 .

model interest rates using dynamic basis spreads in the presence of collateral. and the LIBOR curve L. Tj Tj . Mercurio (2008) proposed the double-curve lognormal forward-LIBOR market model. Tj )|F (t)]. i. QAf d : R+ × R++ × [−1. which is essentially an extension of the celebrated LIBOR market model. ρf X ) = exp t Tj −1 µf (u)du.44) We can price an arbitrary interest rate contingent claim by straightforward extension of (2. collateral agreements reduce the discounting rate signiﬁcantly. Additionally. In their model. Kijima et al. is another important contribution of Mercurio (2008).43). (2. Another limitation of Binachetti (2008) is the usage of deterministic volatility.46) Binachetti (2008) fails. the collateralized forward-LIBOR rate. 1] → R. The DLG model is consists of three curves. (2011). (2010) model the term structure of interest rates under collateralization. perceived in the post-crisis market environment. Tj −1 . Kijima et al. in the pre-crisis pricing framework EQd [Ff (Tj −1 . Fujii et al. The documentation of wide basis spreads. ρf X ) = 1. Collateralization is an important credit risk mitigation tool in over-the-counter (OTC) markets. (2010). Tj −1 . Regrettably. to elaborate on how to derive the discounting (“domestic”) curve in a consistent way. Tj −1 . relative to the LIBOR rate. σ f . All cash ﬂows are discounted along the D curve. he proposed new formulas for some major plainvanilla instruments. (2. an extension of Fujii et al. is deﬁned by ∫ QAf d (t.45) QAf d (t. σX . (2008) proposed the DLG model. σX . where the multiplicative “quanto” adjustment QAf d . LIBOR deposit rates are implied by the L curve and government bonds are prised along the G curve. a government cure G. Tj )|F (t)] ≡ EQf [Ff (Tj −1 . which does not allow for arbitrage opportunities. however. σf .. Through mark-to-market and collateral postings. (2. Tj −1 . D.17 for t0 ≤ t ≤ Tj −1 . (2008) fail to elaborate on how to derive the discounting curve D. Fujii et al.e. a discount curve D. They deﬁne the collateralized zero-coupon bond. Needless to say.

. T . Tj ). τ ) − LOIS (t. τ )⊤ dW T c (t) def .48) [ ( )] 1 1 c ETj − 1 .47) def . Tj −1 . τ )⊤ dW Q (t). τ )σB (t. On the demand side. def . Even if the credit risk were not existent because of collateralization. τ ) = σB (t. QTc − a. Tj .50) . (2. the assumption that all contracts can be collateralized is unfounded. τ )⊤ B (t. by panic or default of a major interbank counterparty . τ ) = B (t. If a model is to § caused. and the collateralized OIS forward rate. LOIS . τ ) (∫ t T ) σc (t. Tj −1 . τ ) LOIS (t. Collateral postings are not executed on a continuous basis. by D(t. a shortage of collateral will continue to exist. Tj ) Tjc where T c stands for the collateralized forward measure. Even if the notional amounts in the OTC market were netted. under the equivalent martingale measure Q. T . Tj . T .. Even though collateralization mitigates credit risk. 0 ≤ t ≤ T.18 Lc . There is an additional problem inherent to collateralization. follows dB (t. = = e− ∫T t c(t. = E [L(Tj −1 . 0 ≤ t ≤ T. τ ) = Lc (t. Tj .s)ds . as regulators push over-the-counter derivatives towards central clearing counterparties (CCPs). there would be a signiﬁcant shortfall in assets suitable for collateral. QTc − a. B (t. The stock of “risk-free” government bonds. and c(t. a signiﬁcant amount of liquidity risk can still be present. Tj −1 . (2. Tj . T . is shrinking. the most common type of collateral. Thus. (2. (2. T . as the creditworthiness of certain governments has become more questionable.51) under the collateralized forward measure T c . it does not eliminate it. T .s.49) (Tj − Tj −1 ) D(Tj −1 . (2. τ )|F (t)]. Tj −1 . The dynamic LIBOR-OIS spread. and dB (t. s)ds + σB (t. Tj ) def . for example. s) is the spot rate.s. and an abrupt drop in the price of the collateral§ can lead to credit risk exposure. T ) Lc (t. T .

within the general equilibrium framework. or use rates for discounting that are not risk-free (the collateralized discount rate of Fujii et al. Needless to say.. It is clear from these considerations that collateralized rates are not risk-free and cannot be used for discounting. All of the post-crisis pricing models presented in this section either fail to derive the discounting curve in a rigorous fashion. as well as credit risk.19 account for basis spreads. 2010). we derive a discounting curve in a rigorous fashion. it should price liquidity risk. only risk-free rates can be used for discounting under the martingale measure. . In the next chapter of this thesis.

.

A process in this thesis is by deﬁnition a stochastic process.... Each submarket Mk .. where Qk is a probability measure equivalent to P. Z ⟩(t) = 0. we deﬁne a continuous-time ﬁnancial market.. P). . d⟨Wi. We shall further assume that F = F (T ). i ∈ {1. F.... and d⟨Bq .T ] .. and a Rd -valued Brownian motion B . F. Z ⟩(t) = 0. n + 1}.j dt. ..1 Notation The stochastic basis (Ω. l}. M. n}. .. j ∈ {1. on the ﬁltered probability space (Ω. Mn+1 ≡ Md . P) is assumed to carry a Rl×n -valued standard Brownian motion W . q ∈ {1. where d + 1 ≤ l.. F .j . The market M consists of n + 1 submarkets. that is progressively measurable. . is characterized by (Ω. 21 . n}.i. Wi. j ∈ {1.. Brownian motions Z and W drive the stochastic process of the forwarding rate in the stochastic volatility forward-LIBOR market model. {F (t)}t∈[0.. whereas we intend to use B in the general equilibrium model proposed in this chapter. . Finally. with respect to {F (t)}.. k ∈ {1. We denote by F = FB ∨ FZ ∨ FW the augmented ﬁltration. F. .. F . i ∈ {1. a R-valued standard Brownian motion Z . i ∈ {1. d}. d}.. Qk ). F . Let d⟨Bi ..j ⟩(t) = ρ ˜q.. generated by the Brownian motion. .Chapter 3 Equilibrium Instantaneous Interest Rate Derivation 3. l}...

t∈[0. (3.. Lp (S ) = {x ∈ L(S ) : 0 ||x(t)||p dt < ∞.. 2. ∀x. In each state of the world. 0 ≤ t ≤ T. The rest of the market consists of trading in m risky assets with excess returns R = (R1 .7) . We consider a continuous-time ﬁnancial market Md allowing default-free borrowing and lending at a continuously compounded rate given by the process r(·). p = 1.4) In this chapter. P − a. P − a.s. .6) σ R ∈ L2 (Rd×m ). It is the ultimate goal of this chapter to endogenously derive the process of r(·). such that ∫ T [|ψ (τ )µR (τ )| + ||σ R (τ )||2 ψ 2 (τ )]dτ < ∞. A trading strategy is any process ψ ∈ Z (Rm ). x(t)y (t)dt + x(T )y (T ) .2) 0 { [ ] } Z def . (3. 2 2 H = x ∈ L(R) : E x (t)dt + x (T ) < ∞ . we adopt the notation of Schroder and Skiadas (2003) and Skiadas (2008). µR ∈ L1 (Rm ). Rm )⊤ following dR(t) = µR (t)dt + σ R (t)⊤ dB (t). y ∈ H.5) (3.. We deﬁne the spaces of real-valued processes: { [∫ T ] } def . R(0) = 0. there is a single consumption good. 3. a..s. we consider an exchange economy endowed with continuoustime ﬁnancial markets. (3. we deﬁne L(S ) to be the set of all S -valued. 2 2 H+ = x ∈ L(R+ ) : E x (t)dt + x (T ) < ∞ . 0 (3.}.s.3 The Financial Market In the sequel.1) 0 { [∫ T ] } def .2 Preliminaries Given any subset S of the Euclidean space. progressively measurable processes and with ||·|| denoting the usual ∫T Euclidean norm.22 3. = x ∈ L(R) : E ess sup |x(t)| < ∞ . (x|y ) = E 0 (3.T ] (3.3) The space H will be regarded as a Hilbert space with inner product ] [∫ T def .

(1997). Following Duﬃe and Epstein (1992b). e. Deﬁnition 3. where V (0) stands for the initial utility.g. we specify the recursive utility function. Let (f. Skiadas (2008).4. . see. e. is deﬁned by U (0. c) = V (0).9) 2 0 ≤ t ≤ T. we deﬁne a stochastic diﬀerential utility. Then V (·) is the stochastic diﬀerential utility (SDU) process for c ∈ H+ under (f. z ) be an aggregator∗ such that z is smooth at certainty and has a measurable variance multiplier A. U (0.s.23 We interpret the i-th component of ψ (t) as the time-t proportion of wealth invested in the [risky] traded instrument i ∈ {1. (3. m}. . Next. (3.8) 2 ds t We assume that f : C × R → R and A : R → R. z ) if V (·) is the unique square-integrable (F (·). we think of the progressively measurable process c(t). Karoui et al. T ] → R+ .. 0 < t < T . Given the consumption plan C ∋ c : Ω × [0. We deﬁne a representative agent characterized by the primitives (U (0). Clearly. as the continuation utility for c ∈ H+ at time t and conditional on F (t). applies penalty as a multiple of the utility volatility. (3. U (0) : C → R. The stochastic diﬀerential utility function. See. e(·)). c). d ⟨V ⟩(s).8) satisﬁes the backward stochastic diﬀerential equation (BSDE† ) ( ) 1 2 dV (t) = −f (c(t). ∀t ∈ [0.1. P − a. ∗ † For a deﬁnition. we interpret V (t).4 The Economy The convex cone C ⊆ H+ is a set of consumption plans. the remaining wealth being invested in the risk-free asset. ||σv (s)||2 = ds σv (·) ∈ L2 (Rd ) is assumed to be progressively measurable. 3. The variance multiplier A(V (·)) def .g. V (s)) + A(V (s)) ⟨V ⟩(s) ds F (t) . while c(T ) represents the terminal consumption. Following Duﬃe and Epstein (1992a). P)-semimartingale satisfying [∫ T ( ) ] 1 d V (t) = E f (c(s). T ]. as the time-t consumption rate. V (t)) − A(V (t))||σv (t)|| dt + σv (t)dB (t).. where U (0) : C → R is a stochastic diﬀerential formulation of the recursive utility function and e(0) ∈ R++ is the initial wealth (endowment) of the agent. We denote by e ∈ H+ the endowment stream of the agent...

i. ψ ) is optimal. T ]. . and dynamically consistent consumption and investment strategy. b) ≥ U (τ. Let A be the set of all admissible strategies. b) > U (τ. is the sum of the gains or losses produced by trading in risky assets and the exchange of consumption goods. with the inequality being strict if P[U (τ. 0 The pair (c. (3. If U (0. Assumption 3. In the sequel. 2. if the process P (·) is nonnegative and e(T ) = P (T ) ∈ R+ .5). T ]. (Skiadas.11) Equation (3. ψ ) is said to be optimal if and only if 1. Assumption 3. ∀t ∈ [0. and P[U (τ. ψ ) is admissible.2.s. For a given R. In addition to that.4. 2008) Suppose two consumption plans a and b are equal up to a stopping time τ ∈ [0. the wealth process P (·) associated with the consumption-investment strategy (c. ψ ) is deﬁned as the unique semi-martingale that satisﬁes ∫ t ∫ t P (t) = e(0) + ψ (τ )P (τ )d[r(τ ) + R(τ )] − [c(τ ) − e(τ )]dτ. the pair (c. we assume that (c. recursive utility can disentangle risk aversion and intertemporal substitutability. i. a. ψ ) ∈ A. a)] > 0.s. We give a deﬁnition of admissible consumption and investment pair for future reference. (c.1. the stochastic diﬀerential formulation of recursive utility. exhibits intertemporal consistency and admits Bellman’s characterization of optimality. ψ ) ∈ A. (c. ψ ) ∈ A. (c.10) 0 0 ≤ t ≤ T.e.10) states that the wealth P (·) at the time t. Given the stochastic process (3. P − a. Deﬁnition 3.. We assume that (c. Deﬁnition 3..4.24 As it is explained in Duﬃe and Epstein (1992a).e.4. b) ≥ U (0.3. a). then consumption plans a and b are said to be dynamically consistent.4.4. ψ ) is dynamically consistent and maximizes the utility of the agent. Deﬁnition 3. ψ ) is said to be admissible.2. (3. (c. deﬁned above. a)] = 1.4.

⊤ = k (¯ v − v (t))dt + σv dB (t). we assume that the economy deﬁned above is in a state of Radner Equilibrium. Remark 3. that is to say that c(t) = e(t). Deﬁnition 3. 0 ≤ t ≤ T. dP ⊗ dt − a. (3. σv ∈ Rm .7. c + x) ≤ U (0.4. ∀x ∈ H}. c) + (π |x). Since the economy is in a state of Radner Equilibrium. . (2009).4.14) Deﬁnition 3. R} is a Radner equilibrium. Throughout this thesis. Without loss of generality. Assumption 3. v ¯ is the mean-reversion level. ψ (t)) is optimal.4.13) Clearly.5. ∀t ∈ [0. We now deﬁne a couple of useful concepts for further reference. we assume that the stochastic growth process of the aggregated endowment process is governed by the stochastic diﬀerential equation (SDE) de(t) e(t) dv (t) e(0) v (0) ⊤ = (v (t) − β )dt + σe dB (t).1. ψ ). (3. they are treated at length in Skiadas (2008). and v ¯ are assumed to be constants. A process π ∈ H is a state price density at c ∈ C ⊆ H+ if (π |x) ≤ 0 for any x ∈ H such that c + x is a feasible consumption plan.4. we present a variant of Dana and Jeanblanc’s (2007) deﬁnition of the Radner Equilibrium. Following Nakamura et al. • markets clear. at the time t.25 Next. A process π ∈ H is a supergradient density of U (0. c) at c ∈ C ⊆ H+ if U (0. c(t) = e(t). The pair {(c. σe . if • the pair (c(t). whereas k is the mean-reversion speed. 0 ≤ t ≤ T. 0 ≤ t ≤ T . v (·) is stochastic and follows a mean-reversion process.12) (3. ∈ R+ .e.3. Exhaustive exposition on the subject may be found in Dana and Jeanblanc (2007). Deﬁnition 3. ∈ R.6. We deﬁne the set of state price densities at c by Π(c) = {π ∈ H : (π |x) ≤ 0.4. T ].

Given any (a. . t. c.18) and E[supt [E (fV . t. c. e. t. c) = V (0) at c. c. Proof.19) Provided it belongs to H. b)(t) = a(t)dt + b(t)dB (t). V ) (3. t. U + y ) + qy. b)(0) = 1. (3. E (a.4. we let E (a. ∂V ∂c (3. c. U ) ≤ F (ω. which is the partial derivative of F with respect to U . c. V (·)). such that ( ∂f ∂f . ∂c ∂V ) ∈ ∂F (c. 0 ≤ t ≤ T. P − a. ·) is diﬀerentiable. b)(t) E (a. we deﬁne the superdiﬀerential of F at U as the set (∂U F )(ω.17) In particular. if F (ω. 0)(t)]2 ] < ∞.. such that F (ω. (3.15) (3.26 Deﬁnition 3. Suppose that V is a recursive utility with aggregator f (c(·).1.9. y ∈ R.s.0 . Proposition 3. T ] × R++ × R → R. t. b) denote the stochastic exponential with dynamics dE (a. the process ξ (·) is a supergradient density of U (0.. Skiadas (2008).8.4. For alternative derivation of (3.4.16) Deﬁnition 3. b) ∈ L1 (R) × L2 (R). See. Let the process ξ (·) be deﬁned by ( ξ (·) = E ) ∂f ∂f . U ) that is the set of all q.g. U ) consists of a single element FU (ω. t.19). For any function F : Ω × [0. see Duﬃe and Epstein (1992b). U ). (∂U F )(ω. c.

. ∂c∂v DC (·) stands for the diﬀusion coeﬃcient of (·). ∂c 0 ≤ t ≤ T. ξ (t) fc (c(t). i. ∂c2 fcv (e(t). V (t)) where fV (c(t). By Theorem 7 of Schroder and Skiadas (2003). V (t)) where fcc (e(t). (3. The pair (ψ. J (t)) = fv (e(t). Then by Proposition 3 (First-order conditions).23) fc (e(t). ξ ∈ Π.22).s. V (t)). ξ is a state price density at c. e(t)) = V (t). we infer that ( ) dfc (e(t).s. (3. Then. e(t)). J (t)). P − a. V (t)) − . Schroder and Skiadas (2003). V (t)) r(t) = − = −fv (e(t). ξ ∈ Π implies dξ (t) = −r(t)dt − λ(t)dB (t). J (t)) = σe (t) − ∗ + σv (t) − ∗ . J (t)) fcv (e(t).20) In equilibrium.21) and (3.s. J (t)) 0 ≤ t ≤ T. V (t)).22) By comparison of (3.27 By straightforward application of Itˆ o’s lemma.24) fc (e(t.19) implies dξ (t) dfc (c(t).25) ξ (t) fc (e(t). and D(·) stands for the drift term of (·). (3. J (t))dt + . J (t)) Dξ (t) Dfc (e(t). V (t)) = fV (c(t).. Let v be the equilibrium value of J (t. J (t)) = ∂ 2f (e(t). ∂V fc (c(t). e(·) = c(·). ξ (t) 0 ≤ t ≤ T. P − a. J (t)) ( ) ( ∗ ) ∗ efcc (e(t). c) is optimal and ξ ∈ H is a utility supergradient density of U (0) at c. V (t)) = ∂f (c(t). V (t)) = ∂f (c(t). J (t)). P − a.20) becomes dξ (t) dfc (e(t). Obviously.24) and (3. (3. J (t)) λ(t) = DC − (3. (3. (3.25) are respectively the market price of risk and the instantaneous equilibrium risk-free rate. V (t))dt + . ξ (t) fc (e(t). J (t))) fc (e(t)..e. J (t)) = ∂ 2f (e(t).21) where V (t) = J (t. (3. . (3.

λ(t) = σe − α(q (t)σe + m ˜ (t)σv ). We intend to use this rate solely for discounting under the martingale measure when pricing interest rate derivatives.9.4.. see the Appendix of Nakamura et al.2. (based on Theorem 3. s ∈ [0. e(·)) is governed by the backward stochastic differential equation (BSDE) dJ = −f DE (e.1 is the equilibrium instantaneous risk-free rate. m ˜ (t) = Proof.. By deﬁnition. def .31) Remark 3.13) under the time-nonseparable utility (3.28) in Theorem 3.13) of the endowment process. Q − a.29) where q (t) = 1 − e−β (T −t) .28 Under the speciﬁcation (3.32) (3. (3. v ) = β (1 + αv ) log c − .s. 0 ≤ t ≤ T. = dB P (t) + [σe − α(q (t)σe + m ˜ (t)σv )]dt. the equilibrium instantaneous risk-free rate is distinct from the LIBOR rate observed in the market.26) where f = f DE stands for the Duﬃe-Epstein (1992b) aggregator deﬁned by ( ) log(1 + αv ) def . (3. For a detailed proof.33) .28) (3. T ].4.27) α Theorem 3.30) − e −β (T −t)−e−(k+β )(T −t) k . 0 ≤ t ≤ T. The interest rate (3. the utility function V (·) = J (·. we need the process of v under the equivalent martingale measure Q. DE f (c. P − a.4. By the theorem of Girsanov-Maruyama. we obtain dB Q (t) = dB P (t) + λ(t)dt.s.1.27). J )dt + (Je eσe + Jv σv )⊤ dB (t). (3.12) − (3.1 and Lemma A. s). 2009) Suppose the economy with endowment process is given by (3.12) − (3. In order to derive the price of the stochastic discount factor P (·. (3. 1−e k+β −(k+β )(T −t) (3. (2009). Then the instantaneous riskless rate and the market price of risk become ⊤ r(t) = v (t) − σe λ(t). (3. Nakamura et al.

def .40) (s − t) − 2 + . ∀t ∈ [0.39) t t ) ∫ s (∫ u 2 −k(u−τ ) −α||σv || e m ˜ (τ )dτ du. (3. Q − a.35) Lemma 3. When r(·) follows (3. s).44) . − (3. is given by P (t.35).42) t (∫ s ) [ ( ∫ s )] ⊤ Q = exp σe λ(u)du E exp − v (u)du Ft . s) = E exp − r(u)du F (t) (3. where A1 A2 A3 def .28) and v (·) follows (3. s) = exp(A1 + A2 + A3 + A4 ). k2 k 2k t ⊤ σe [ From the deﬁnition of a discount bond. 0 ≤ t ≤ T.34) (3. we obtain ∫ u −k(u−t) v (u) = e v (t) + k v ¯ e−k(u−τ ) dτ t ∫ u ∫ u −k(u−τ ) ⊤ ⊤ e−k(u−τ ) dW (τ ). we have [ ( ∫ s ) ] Q P (t. (3. the price of the discount factor P (t. T ].43) t t By straightforward integration of (3. (3.29 ⊤ dv (t) = [k (¯ v − v (t)) − σv (σe − α(q (t)σe + m ˜ (t)σv ))]dt ⊤ Q +σv dB (t).41) t [ ( ∫ s ) ] Q ⊤ = E exp − v (u) − σe λ(t)du F (t) (3. A4 Proof.35).38) k k ) ∫ s (∫ u ⊤ −k(u−τ ) −ασv σe e q (τ )dτ du (3. e λ(τ )dτ + σv −σ v t t (3.36) = = = def . (3.4. T ].s.1. t t ( ) ( )) ∫ ( 1 − e−k(s−t) 1 − e−2k(s−t) ||σv ||2 s (3. ∀s ∈ [t. def .37) s−t t ( ) ⊤ σe 1 − e−k(s−t) k [¯ v − v (t)] − σv (s − t) − . = ( )] ∫ s 1 −(s − t) r(t) + λ(t) − λ(u)du .

44)..46) (3. v (u)du F (t) .30 From (3. k2 k 2k t Q (3. it is clear that − i. Var − ∼ N E − t t The conditional expectation of the integrated process v is ( ∫ s ) E − v (u)du F (t) t ∫ s ∫ s∫ u −k(u−t) = − e v (t)du − k v ¯ e−k(u−τ ) dτ du t t t ∫ s∫ u ⊤ +σv e−k(u−τ ) λ(τ )dτ du (t t ) ( ⊤ ) ⊤ σv σe ¯) + σv σe 1 k (v (u) − v −k(s−t) (1 − e ) + ( s − t) −v ¯ = − k k k ( ) ∫ s∫ u ∫ s∫ u ⊤ −k(u−τ ) 2 −k(u−τ ) −α σv σe e q (τ )dτ du + ||σv || e m ˜ (τ )dτ du . v (u)du F (t) (3.e. ∫ − t s ∫s t v (u)du|F (t) is a Gaussian random variable.47) (3. Q t t t t The conditional variance of the integrated process v is ( ∫ s ) Var − v (u)du F (t) t ( ) ∫ s∫ u Q ⊤ −k(u−τ ) Var −σv e dW (τ )du F (t) t t ( ⊤∫ s ) σv Q −k(s−u) Var − (1 − e )dW (u) F (t) k t ∫ ) ||σv ||2 s ( −k(s−u) 2 du 1 − e k2 t ( ) ( )) ∫ ( 1 − e−k(s−t) 1 − e−2k(s−t) ||σv ||2 s ( s − t) − 2 + .45) )] ) ( ∫ s [ ( ∫ s Q Q v (u)du F (t) .50) = = = = .49) (3.48) (3.

(3. k t (3. we obtain the discount bond price ) (∫ s ⊤ σe λ(u)du P (t.52) (3. we used the following property ∫ s∫ u ⊤ σv e−k(u−τ ) dW (τ )du ) (∫ u ) ∫t s (t∫ u ⊤ kτ −kv = σv e dW (τ ) du e dv t t t (∫ s ) ∫ s ⊤ ku −kv = · · · = σv e e dv dW (u). s) = exp t [ ( ∫ s ) ( ∫ s )] 1 Q Q × exp E − v (u)du F (t) + Var − v (u)du F (t) .48) we used Itˆ o’s isometry.56) . 2 t t P (t.55) (3.51) (3.54) In the derivation of (3. Using the above results.49) from (3.31 To obtain (3. s) = exp(−(s − t)r(t) + (s − t)r(t)) ( ) ∫ s 1 Q Q ⊤ × exp E (·) + Var (·) + σe λ(u)du 2 t = exp(A1 + A2 + A3 + A4 ). t u ⊤ ∫ s σv = (1 − e−k(s−u) )dW (u).47).48) from (3.53) (3.

.

instruments diﬀering only in the length of their tenor can be perceived as indistinguishable. This is because there are considerable spreads between instruments with diﬀerent tenors (see Mercurio. it is straightforward to compute the discounting and forwarding curves from it.1 Preliminaries In a market environment where basis spreads are close to zero. In a distressed market environment characterized by credit and liquidity risk-induced basis spreads. it is inadvisable to price plain-vanilla and complex interest rate derivatives on a single curve.Chapter 4 Multi-curve Extension of the SV Forward-LIBOR Market Model 4. For a graphical summary of this approach. the spot curve can be bootstrapped from a set of liquid market instruments with diﬀerent tenors using interpolation/extrapolation techniques and splines. This is possible. Once the spot curve is estimated. We consider two sets of curves. In this thesis.e. see ﬁgure (4. i. because when basis spreads are close to zero.1). and the set of for33 .. such as LIBOR-OIS (EONIA) basis spreads and tenor basis spreads. the set of discounting curves D. 2008). The market environment during and in the aftermath of the global ﬁnancial crisis of 2007-2009 is an example of a distressed market environment. we propose a multi-curve extension of Piterbarg’s (2003) celebrated stochastic volatility forward-LIBOR market model.

The forwarding curve and the discounting curve used for pricing are derived from the spot curve. .1: Interest rate derivative pricing in the absence of basis spreads. Figure 4.34 A spot curve is bootstrapped from a set of liquid market instruments with arbitrary tenors.

Market M consists of submarkets (M3M . 12M } is inhabited by ﬁnancial instruments. Submarket Mi . and SWAPS. M12M ). with the tenor being equal to i months. Figure 4. e. the calibrated model can be used for interest rate derivative pricing. Subsequently.2: Interest rate derivative pricing in a distressed market environment. futures.35 We deﬁne a continuous time ﬁnancial market M..g. The model is augmented with a discounting curve derived from a general equilibrium model. One can use the three forwarding curves and the discounting curve to calibrate her interest derivative pricing model of choice. LIBOR rates. 6M. i ∈ {3M. M6M . A single spot curve is bootstrapped from every submarket. .

4. In order for arbitrage opportunities to be ruled out. Z ⟩(t) = ρdt. . with instantaneous correlation ρ.. we assume ρ = 0. Tj . is the underlying instrument. Qk ). . (2008) employed Vasicek and Quadratic Gaussian models. (2008). and the well-known Joshi and Rebonato (2003) model. the Wu and Zhang (2002) model. is deﬁned on the ﬁltered probability space (Ω. Lesniewski and Woodward (2002) model. and we do not discriminate between ”government curve” and ”discounting curve”. Without loss of generality.. the major contribution of this thesis. Wjk (·) and Z (·).36 warding curves W .Brownian motions. k ∈ {1. Let {1. Qk j ).. n} and denote by Fjk (·) the forward rate associated with curve k . i. It should be noted that it is straightforward to apply our results to diﬀerent speciﬁcations of the stochastic volatility LIBOR market model.. such as the Andersen and Brotherton-Ractcliﬀe (2001) model.. that of Kijima et al.. we assume that Fjk (·) and its variance z (·) T are driven by two one-dimensional (F (·). there exists a unique discounting curve. F . Gatarek. n}. F. k ∈ {1. the Hagan. Note that our model is similar in some respects to. i. one for each tenor. ∗ . Kumar. Each submarket. We index the forwarding curves by k ∈ {1. since our model does not consist of three curves. The instantaneous forward rate Fjk (·) = Fjk (·. we assume throughout the thesis that the set D is a singleton.. l} be the set of forward rate maturities. . n + 1}. The LIBOR market model is also known as the LFM (Log-normal Forward Model) or the BGM model after Brace. d⟨W.e. whereas we use the stochastic extension of the LIBOR market model in its formulation proposed by Piterbarg (2003). F.. F . For discounting we use the curve derived from a general equilibrium perspective in the previous chapter. Also Kijima et al. ..2 Model Deﬁnition In this section. Tj ) maturing at time Tj and deﬁned on submarket Mk . The multi-curve extension of the Stochastic volatility forward-LIBOR market model consists of n + 1 curves (n forwarding curves and one discounting curve).. P). we introduce the multi-curve extension of the stochastic volatility LIBOR market model∗ .... The set of forwarding curves W consists of multiple forwarding curves.. In the following. but distinct from. Each forwarding curve carries its own speciﬁc credit and liquidity risk premia and is deﬁned on a submarket. and Musiela (1997). Mk .e. We deﬁne n + 1 submarkets of market M ∈ (Ω.

Qk j . η ∈ R.7) def .4) in the form of λ∗ [φ(Fjk (0)) + φ′ (Fjk (0))(Fjk (t) − Fjk (0))] = λ[bFjk (t) + (1 − b)L]. Qk j − a. of Fjk (·) ∈ Mk . the the process of z (·). (4. def . By Taylor’s approximation of φ(Fjk (t)) for Fjk (t) near Fjk (0). We now deﬁne: λ b L def . (4. Qk j )-martingale. Needless to say. φ : R+ → R is a model-speciﬁc map. In the literature. the T variance process z (·) is not driftless under measure Qk j . = λφ′ (Fjk (0)) = Fjk (0).8) . T Tj T T 0 ≤ t ≤ T. and ψ : R+ → R. Qk j is also known as the Tj -forward measure of Fjk (·) ∈ Mk .5) (4. As we prove in the sequel.6) (4. m ∈ L1 (R) is the mean-reversion level of the variance.2).s. the T stochastic process of Fjk (·) follows a (F (·).3) T where Wjk (·) and Z (·) are Qk j -Brownian motions. Fjk (0) Fjk (0) . We denote by EQk [·|F (t)]. ∀t ≥ 0 the expected value operator under measure Qk j and conditioned on F (t).1) dz (t) = θ(m(t) − z (t))dt + ηψ (z (t))dZ (t). Pk (·.37 Let Qk j be the equivalent martingale measure corresponding to the natT ural num´ eraire. z (0) = 0.4) = λ∗ φ(Fjk (0)) . φ(Fjk (t)) ≈ φ(Fjk (0)) + φ′ (Fjk (0))(Fjk (t) − Fjk (0)). (4. In general. the stochastic process of the forward rate in the multi-curve stochastic volatility forward-LIBOR market model evolve according to √ T dFjk (t) = λ∗ φ(Fjk (t)) z (t)dWjk (t). Without loss of generality. Following Andersen and Piterbarg (2010). φ(Fjk (0)) (4.. λ∗ ∈ R is an arbitrary constant. In its most general form.2) (4. 0 ≤ t ≤ T. is not submarket-speciﬁc. (4. Tj ) ∈ Mk . deﬁned in (4. we specify the coeﬃcient of the volatility of the underlying φ(·) as follows. we assume that the mean-reversion speed θ is constant. and rewrite (4.

(4. 0 ≤ t ≤ T.9) follows a displaced diffusion process (DDP). Qk j − a..38 Specifying the functional form of φ(·) as above. Fjk (·). (4. n}. we give a formal deﬁnition of the multi-curve extension of the stochastic volatility forward-LIBOR market model proposed in this thesis.9) dz (t) = θ(m(t) − z (t))dt + ηψ (z (t))Z (t). Tj ).2. Parameter b can be used as a free parameter for calibration of the model to market data. deﬁned on Md . .16) (4. a. let the forward rate. 0 ≤ t ≤ T.. 0 ≤ t ≤ T.14) Let the discounting curve. 0 ≤ t ≤ T. Deﬁnition 4. evolve according to √ dFjk (t) = λ(bFjk (t) + (1 − b)L) z (t)dWjk (t). the process of the underlying Fjk (·) in (4.s. the coeﬃcient will be almost constant.15) T . (4. For k ∈ {1. Mk .... for values of b close to 0.1) − (4.10) z (0) = 0. (4. Conversely. For high values of b. be given by Tj → Pd (·. the coeﬃcient of the volatility z (·) will be highly state-dependent. We can interpret√ b as a weighting factor. √ T dFjk (t) = λ(bFjk (t) + (1 − b)L) z (t)dWjk (t).13) z (0) = 0..s.2). (4. (4.s. Tj ) = exp(C1 + C2 + C3 + C4 ). we obtain the following simpliﬁed version of the forward rate (4. Using the forward rates dynamics elaborated above and the results from the previous section.11) Clearly.1. Qk j − a.s.12) dz (t) = θ(m(t) − z (t))dt + ηψ (z (t))dZ (t).. (4. where Pd (t. a. deﬁned on submarket k .

inhabiting submarket Mk . (4.13) admits a solution of the form: 1 k (t) − (1 − b)L]. (4.15) the multi-curve extension of the stochastic volatility forward-LIBOR market model.18) k k ) ∫ Tj (∫ u −k(u−τ ) ⊤ e q (τ )dτ du −ασv σe (4. − C4 def .. we derive a closed-form solution for the forward rates in the multi-curve stochastic volatility forward√ LIBOR market model when ψ (z (·)) = z (·). Conventional pricing theory and results can be applied to a full extent in the vicinity of every submarket (we show this later in our caplet pricing example). where the payoﬀ of an arbitrary contingent claim spans multiple submarkets. k ∈ {1. We call the model given by (4.19) t t ) ∫ Tj (∫ u 2 −k(u−τ ) α||σv || e m ˜ (τ )dτ du. Later in the thesis. = ( )] ∫ Tj 1 λ(t) − −(Tj − t) r(t) + λ(u)du .21) . we deal with the diﬃculties we encounter when we price interest rate contingent claims spanning multiple submarkets at a time.3 Solution of the Multi-curve Stochastic Volatility LIBOR Market Model Proposition 4.17) Tj − t t ( ) ⊤ k [¯ v − v (t)] − σv σe 1 − e−k(Tj −t) − (Tj − t) − . Next.1. (4. 4. Fjk (t) = [(bFjk (0) + (1 − b)L)Xj b (4... def . Finally. Following Andersen and Piterbarg (2010a). . The model (4.20) t t ( ) ( )) ∫ ( 1 − e−k(Tj −t) 1 − e−2k(Tj −t) ||σv ||2 Tj (Tj − t) − 2 + . we show that conventional pricing theory holds within every submarket by pricing a caplet.12) − (4. k2 k 2k t ⊤ σe [ is the equilibrium price of the risk-free bond derived in the previous section. we pay special attention to the more involved case. C1 C2 C3 = = = def .39 def . n}.3.12) − (4.

i. In the sequel.4. entirely in the vicinity of submarket Mk . Xj ∫ t√ ∫ 1 2 2 t k = λb z (s)ds. Proposition 4. t) = EQk (eu ln X (t) ) = EQk (X (t)u ). T (4. k Xj (t) 0 ≤ t ≤ Tj −1 . Qk j − a. Proposition 8.26) . Proof. it is straightforward to derive (4. k (t) ln Xj k (0) = 1.21).24) z (0) = 0. z (s)dWj (s) − λ b 2 0 0 0 ≤ t ≤ Tj −1 .s. def .3. Qk j − a.4 Caplet Pricing in the Multi-curve Stochastic Volatility Forward-LIBOR Market Model In this subsection.22) (4. T (4.. we calculate the price of a caplet in the multi-curve stochastic volatility forward-LIBOR market model without explicitly resorting to discounting. deﬁned on submarket Mk ..1.23) z (0) = 0.e. Tj Tj (4.7) Deﬁne ΨX (u.40 where k √ dXj (t) = λb z (t)dWjk (t).25) By applying Itˆ o’s lemma to ln(bS (t)+(1 − b)L). we can price an arbitrary caplet. (4. we extend the call option pricing approach proposed by Andersen and Piterbarg (2010). Without the need for explicit discounting.s. (extension of Andersen and Piterbarg (2010a).. 4.

33) for any 0 < α < 1. t .4.41 In the model (4. ¯ 2 where we have denoted ∫ t def . . X (u) = E(euξ ). 0 Under the new probability measure Qk . for any u ∈ C for which the right-hand side exists. i.s.. u. Let ξ be a random variable.. t) = E (e (t)). the process for z (·) is √ ˜ (t). 0 ≤ t ≤ T. Qk − a.27). Qk v z def .32) Then for any k ∈ R.27) ¯(v. (α + iw)(1 − α − iw) (4.31) 2 0 0 Letting ζ (·) be the Radon-Nykodim derivative. and deﬁne its moment-generating function by X (u). Proof.30) ζ (t) = E uλb 0 ( ) ∫ t√ ∫ 1 2 2 2 t def . From (4. we obtain E Qk j T ( e u ln X (t) ) =E Qk j T ( ( )) ∫ t 1 2 2 ζ (t) exp u(u − 1)λ b z (s)ds . (4. ¯ Ψz z ¯(t) = z (s)ds.1) follows from Girsanov-Maruyama’s theorem. we have ( ) 1 2 ΨX (u.4.1. u.28) Tj ˜ where Z is a Qk -Brownian motion. dz (t) = (θ(z (0) − z (t)) + ρηλbuz (t))dt + η z (t)dZ (4. Qk ≡ Qk .e. (4. ek E((e − e ) ) = X (1) − 2π ξ k + ∫ ∞ −∞ e−k(α+iw) X (α + iw) dw. 2 0 T (4. We note that if ρ = 0.1) − (4.29) where ζ (·) is the exponential Qk j -martingale ) ( ∫ t√ k z (s)dWj (s) (4. Theorem 4.2). Proposition (4. t) = Ψz (λb) u(u − 1). k = exp uλb z (s)dWj (s) − u λ b z (s)ds . (4.

Tj .. n}. cap rate K .. by Cplk (t.34) k Proposition 4. K ). Tj . (4. u. Tj −1 . with F ′ j (0) k def . in the multi-curve stochastic volatility forwardLIBOR market model (4. 2πb −∞ w2 + 1/4 k where CplBLACK (0. λb) (4.27).36) b ∫ ′ ′ K ′ ∞ e(1/2+iw) ln(S /K ) q (1/2 + iw) − dw. def . Tj −1 . CplSV (0. The time t = 0 price of a caplet.2) is given by k CplSV (0. we now derive a closed-form solution of the caplet price in the multi-curve stochastic volatility forward-LIBOR market model. def . Tj ) = 1 k CplBLACK (0.37) (4. We denote the price of a caplet at time t. Andersen and Piterbarg (2010a). The terminal payoﬀ of a caplet. Tj ) − K )+ . Tj −1 . 0 ≤ t ≤ Tj −1 . Tj ). = 1 (λb)2 u(u − 1).2.4.35) (4. k ∈ {1.g. bK + (1 − b)L. and tenor δ is given by Cplk (Tj . λb) is the caplet price. deﬁned on submarket Mk . Making use of these results. Tj −1 . for spot F ′ k j (0).42 Proof. Deﬁnition 4.38) K′ We have also deﬁned ( q (u) = Ψz ¯ with Ψz ¯ given by (4. e.4. with reset date Tj −1 . T 2 . Tj ) = δ (F k (Tj −1 . Tj . (4. and volatility λb. = bFjk (0) + (1 − b)L. deﬁned on submarket Mk . See. Tj −1 .1. ) − e2λ 1 2 b2 z 0 T u(u−1) (4.39) .1) − (4... . Tj −1 . settlement date Tj . cap rate K . given by Black’s (1976) ′ caplet pricing formula.

4.Tj 2 ) (t) = θ (m (t) − z (t)) − k k k Tj2 ∑ q =1 1 Z k (t) τm ˜ (4. where Wjk (·) and Z k (·) are Qk j -Brownian motions. In this section. of the variance process in model (4.. Pk (·.42) − a.42) under the Tj2 equivalent martingale measure Qm is given by µ Pm (·..s.. 0≤t≤ z (0) = 0. For m ∈ {1. l}/{j }. .1.. (4.41) − (4. Using market data. Lemma 4. After deriving the dynamics of the forward rates under diﬀerent measures. we reexamine the problem of the pricing of interest rate derivatives.43 Proof..5. Qk j − a. In general. k (t) + τk Fy . Tj ). T k T Tj −1 . we succeeded in computing the price of the caplet without resorting to discounting.4.41) (4.. 4. n}/{k } and j2 ∈ {1. . to ﬁnd the price of an arbitrary interest-rate contingent claim. the drift term.1).. the forward rate in the stochastic volatility forward-LIBOR market model follows √ dFjk (t) = λk (bk Fjk (t) + (1 − bk )Lk ) z k (t)dWjk (t).5 Multi-curve Stochastic Volatility LIBOR Dynamics under Diﬀerent Measures Under its natural num´ eraire.s. we have to resort to explicit discounting. we derive the stochastic dynamics of the forward rate under diﬀerent measures. Qk j T (4.44) + ∑ Tj y =1 1 Z k (t) 1 τk ˜ B. µPm (·.43) A 1 + τm Fqm (t) (4.40) 0 ≤ t ≤ Tj −1 .Tj2 ) . This result follows from a straightforward application of Proposition (4..1) and Theorem (4. dz k (t) = θk (mk (t) − z k (t))dt + η k ψ k (z k (t))dZ k (t).

Fy k 1 + τk Fy (t) dt + (4. ln(1 + τm Fqm (·)) − ln(1 + τk Fy (·)) (t) dt q =1 y =1 ⟨ ( +θk (mk (t) − z k (t)) = θk (mk (t) − z k (t)) − ∑ Tj2 q =1 Tj ∑ y =1 µPm (·.45) √ k η k ψ k (z k (t))λk (bk Fy (t) + (1 − bk )Lk ) z k (t)ρB1 .Tj2 ) (t) (4. ln (t) (4. = (4. ln ∏Tj (t) k (·) dt 1 + τ F k y y =1 ⟨ ⟩ Tj2 Tj ∑ ∑ 1 k − d ln Z k (·). = Proof. (4. The Tj2 Tj num´ eraries corresponding to Qk and Qm are respectively Pk (·.54) . we obtain the drift term under measure Qm : T T (4.44 where ˜ A ˜ B ρA1 ρB1 def . Z k (t)). Fqm (·)⟩(t) k m ( t ) Z (t) 1 + τm Fq dt 1 Z k (t) 1 τk k (·)⟩(t) d⟨Z k (·).48) def .50) dt Pm (·.52) 1 1 τm d⟨Z k (·).46) corr(Wqm (t). corr(Wy def . Tj ) 1 = θk (mk (t) − z k (t)) − d ln Z k (·).47) (4. Tj ) ∈ Mk and Pm (·. Using the change of numeraire toolkit of Brigo and Tj2 Mercurio (2006).51) (4.49) )⟩ Pk (·. = def . j2 We perform a measure change from measure Qk j to measure Qm . Tj2 ) ∈ Mm .53) (4. Tj2 ) ⟨ ( ∏Tj )⟩ m 2 1 + τ F ( · ) 1 m q q =1 = θk (mk (t) − z k (t)) − d ln Z k (·). Z k (t)). k (t). (4. = √ η k ψ k (z k (t))λm (bm Fqm (t) + (1 − bm )Lm ) z m (t)ρA1 .

...61) is given Tj2 by (under the equivalent martingale measure Qm ) mPm (·. Lemma 4.63) λk (bk Fjk (t) + (1 − bk )Lk )Z (t)[Cρ .59) − a.5. Under the assumption d⟨W.Tj2 ) ..Tj ) (t). . l}... ∀k ∈ {1. mPm (·.1.45 Tj2 ∑ q =1 = θ (m (t) − z (t)) − k k k Tj ∑ y =1 1 Z k (t) 1 τm ˜ A + τm Fqm (t) (4.. Under the assumption d⟨W (·). the process of the variance z k (·) (in the following we omit superscript k ) follows dz (t) = θ(m(t) − z (t))dt + ηψ (z (t))dZ (t). Z (·)⟩(t) = 0. the drift term. T ∀m ∈ {1. For m ∈ {1.s. the multicurve extension of the stochastic volatility forward-LIBOR market model simpliﬁes to √ dFjk (t) = λk (bk Fjk (t) + (1 − bk )Lk ) z (t)dWjk (t). ∀t ∈ [0. Qk j − a. T T. Corollary 4. n}.s..2.Tj2 ) (t) = 1 Fjk (t) ˜ C1 − Dρ ˜ D1 ]. dz (t) = θ(m(t) − z (t))dt + ηψ (z (t))Z (t)...58) (4..55) + 1 Z k (t) τk ˜ B. .. T ]. (4.60) − (4. We restate this result as a corollary. . (4.5.60) 0 ≤ t ≤ T... Z ⟩(t) = 0.. n}/{k } and j2 ∈ {1. 0≤t≤ z (0) = 0.57) Thus under Qk j . the process of z (·) is common for all submarkets. Clearly. Qk j T (4. µPm (·. . l}/{j }. n}..Tj2 ) (t) = µPk (·. 0≤t≤ T T.. ⟨·.61) (4.56) In this proof and throughout the thesis. ∀j2 ∈ {1. k (t) 1 + τk Fy (4. .. ·⟩ stands for quadratic covariation. Qk j (4. (4.s. of the instantaneous forward rate in model (4.62) − a.

ln (4.70) (t) k dt y =1 1 + τk Fy (·) ⟨ ⟩ Tj2 Tj ∑ ∑ 1 k − d ln Fjk (·).72) (4.68) mPm (·.73) Fjk (t) ˜ C1 − Dρ ˜ D1 ]. = = = τm λ m Tj2 ( m m ) ∑ b Fq (t) + (1 − bm )Lm q =1 1 + τm Fqm (t) . def .67) def . def .1)..Tj2 ) (t) ⟨ ( )⟩ Pk (·. Fy k + τk Fy (t) dt (4. Fqm (·)⟩(t) m 1 + τm Fq (t) dt 1 τk k (·)⟩(t) d⟨Fjk (·). Wqm (t)). Wy corr(Wjk (t). ln(1 + τm Fqm (·)) − ln(1 + τk Fy (·)) (t) dt q =1 y =1 = − Tj2 ∑ 1 Fjk (t) q =1 Tj ∑ 1 τm d⟨Fjk (·).66) (4. (4. corr(Wjk (t).64) ˜ D ρC1 ρD1 Proof. we obtain the T drift of Fjk (·) under measure Qk j2 : (4.65) (4. k (t)). Tj ) 1 = 0 − d ln Fjk (·).5. Tj2 ) ⟨ ( ∏Tj )⟩ m 2 1 + τ F ( · ) 1 m q q =1 = − d ln Fjk (·).69) (t) dt Pm (·. λk (bk Fjk (t) + (1 − bk )Lk )Z (t)[Cρ . (4. = τ k λk Tj ∑ y =1 ( k bk Fy (t) + (1 − bk )Lk k (t) 1 + τk Fy ) . Reasoning in the same way as in the proof of Lemma (4.46 where ˜ C def . ln ∏Tj (4.71) + = 1 F k (t) 1 y =1 j 1 (4.

Tj2 ) (t)dt + ηψ (z (t))Z (t). λk (bk Fjk (t) + (1 − bk )Lk )Z (t)[Cρ k Fj (t) (4. and consider an arbitrary F (Tj −1 )-measurable interest rate contingent claim. j2 under the equivalent martingale measure Qm corresponding to the num´ eraire Pm (·. 0 ≤ t ≤ T. e ζ (Fj (t)) = E (4.. Qm − a.77) where mPm (·. We are . Qm − a..s.79) In (4. Proof.47 Theorem 4.74) (4.. 0 ≤ t ≤ Tj −1 . (4.. l}/{j }..s.5.1)..75) j2 dz (t) = µPm (·. .Tj2 ) (t)dt + λk (bk Fjk (t) + (1 − bk )Lk ) × √ Tj2 × z (t)dWjk (t). we consider the pricing of interest rate-contingent claims within the multi-curve extension of the stochastic volatility forward-LIBOR market model proposed in this thesis..5. For m ∈ {1.1. (4. n}/{k } and j2 ∈ {1.2) and Lemma (4.Tj2 ) (t) = 1 ˜ C1 − Dρ ˜ D1 ]. we discount by the risk-neutral interest rate deﬁned on submarket Md and derived from the general equilibrium model in Chapter 3.6 Interest Rate Derivative Pricing in the Extended Model In this section. It is straightforward to prove the theorem using Lemma (4.76) z (0) = 0.61) follows dFjk (t) = mPm (·. 4.Tj2 ) (t) = θk (mk (t) − z k (t)).79). Tj2 ) ∈ Mm . Let 0 < t < Tj −1 < T . T (4. .. (4..5.. Its price at the time t is given by ) ( ∫ Tj k − t r(τ )dτ ˜ Qd k ˜ ζ (Fj (Tj −1 )) F (t) .78) T µPm (·.60) − (4.

82) would be incorrect... Tj ) is the equilibrium price of a discount bond deﬁned on sub˜(F k (·)) is a QTj ˜(F k (·)) = F k (·). Tj −1 . we can calculate the dynamics of the forward rates under the new measure. = Pd (t. n}.80) (4. k ∈ {1. k ∈ {1. using the toolkit introduced in the previous section.83) where QA stands for the adjustment we have to make. We should either model the dynamics of Fjk (·) under T Qd j or use an adjustment similar to that proposed by Binachetti (2008). the price of a caplet deﬁned on submarket Mk . n}. it is not a Qd -martingale. Building on results from the previous section. By straightforward application of this approach. . . . because these rates are neither risk-free.81) where Pd (·. let ζ j j j k Tj martingale.79) in the following way: ( ∫T ) ˜(F k (t)) = EQd e− t j r(τ )dτ ζ ˜(F k (Tj −1 )) F (t) ζ j j ) Tj ( ˜(F k (Tj −1 )) F (t) ..48 not allowed to discount by rates obtainable from bonds deﬁned on submarket Mk . For simplicity. ζ j j (4.7 Multi-curve Extension of the Stochastic Volatility Forward-Swap Market Model When we price swaptions. is given by Cplk (t.. Tj ) = Pd (t. nor unique. we postulate the multi-curve extension of the stochastic volatility forward-swap model. In the latter case. the Forward-swap market model is much more convenient than the Forward-LIBOR market model.. Tj )EQd ζ j (4. Although ζ market Md . We can further simplify (4. Tj (4. In the former case. we obtain EQd Tj ( ) ˜(F k (Tj −1 )) F (t) = ζ ˜(F k (t))QA. and therefore writing EQd Tj ( ) ˜(F k (Tj −1 )) F (t) = ζ ˜(F k (t)) ζ j j (4.. K .84) 4. Tj )δ EQd [(Fjk (Tj −1 ) − K )+ |F (t)].

88) (4... α. Tα ) − Pk (t.87) (4. Let the forward-swap rate. Ti ) (4. the forward-swap rate. T. Tj ).. associated with the num´ eraire β ∑ i=α+1 k Cα. The discounting curve deﬁned on Md is given by Tj → Pd (·.s.β (t) = τi Pk (t. ˆ(m ˆ(ˆ dz ˆ(t) = θ ˆ (t) − z ˆ(t))dt + η ˆψ z (t))dZ (t).β 0 ≤ t ≤ T.β (·).β (t) = λ bSα.49 Clearly.91) . we postulate the multi-curve extension of the stochastic volatility forward-swap market model. n}. Qα. k ∈ {1.s.1.β k k where Wα. is a martingale under the measure Qα.86) In the sequel. z ˆ(0) = 0.. Sα.β (t) + (1 − ˆ b)L √ k z ˆ(t)dWα. n}. k ∈ {1. .89) 0≤t≤ − a.β (t). . (4.7. k Deﬁnition 4. Tj ) = exp(D1 + D2 + D3 + D4 ). (4..β (t) = ∑β .. Ti ).. Pk (t. (4. Qk − a.β k .90) (4.85) deﬁned on Mk . deﬁned on submarket Mk .β k -Brownian motions.β (·) and Z (·) are Qα. evolve according to k k ˆ (ˆ ˆ) dSα. where Pd (t. Tβ ) k Sα.. i=α+1 τi Pk (t.

87) − (4.95) t t ( ) ( )) ∫ ( 1 − e−k(Tj −t) 1 − e−2k(Tj −t) ||σv ||2 Tj (Tj − t) − 2 + k2 k 2k t ⊤ σe [ was derived in the previous section. def . (4. D1 D2 D3 = = = def . (4.92) Tj − t t ( ) ⊤ k [¯ v − v (t)] − σv σe 1 − e−k(Tj −t) − (Tj − t) − . .90) the multi-curve extension of the stochastic volatility forward-swap market model.94) t t ) ∫ Tj (∫ u 2 −k(u−τ ) −α||σv || e m ˜ (τ )dτ du.50 def . = ( )] ∫ Tj 1 λ(t) − −(Tj − t) r(t) + λ(u)du . We call the model given by (4. (4.93) k k ) ∫ Tj (∫ u −k(u−τ ) ⊤ e q (τ )dτ du −ασv σe (4. D4 def .

First. Third. For subsequent research. it can be examined empirically how the price of a particular interest rate derivative changes as we specify an underlying stochastic volatility LIBOR market model―one that is diﬀerent from Piterbarg’s (2003) model. 51 . We summarize our main results in Chapter 4. an investigation may be made into how close the market price of a particular interest rate derivative and the multi-curve stochastic volatility forward-LIBOR market model-implied price are. The line of thought presented in this thesis is particularly appealing in the case of incomplete markets. it would be interesting to examine how the price of an interest rate derivative priced in the model depends on the underlying general equilibrium model. four points are important. where we cannot rely solely on no-arbitrage considerations. in a subsequent paper we intend to examine the empirical feasibility and the computational eﬃciency of the multi-curve extension of the stochastic volatility forwardLIBOR market model. It is a major contribution of this thesis that we augment the extended model with an endogenous discounting curve derived from a general equilibrium perspective.Chapter 5 Conclusion This thesis proposes a multi-curve extension of the stochastic volatility forwardLIBOR market model of Piterbarg (2003). Second. Fourth. We also show how the extended model can be used for interest rate derivative pricing. and is therefore suitable for interest rate derivative pricing in a distressed market environment characterized by wide basis spreads. The model takes into consideration basis spreads.

52 Acknowledgments I am grateful to Professor Takashi Misumi and Professor Koichiro Takaoka for their supervision. LTD. . I am also grateful for the ﬁnancial support I received in the form of a research grant from Mizuho Securities Co. All errors are my responsibility.. as well as to Professor Hisashi Nakamura for his help on the General Equilibrium Model.

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